Thursday, October 29, 2009
7:47:34 PM EDT

Oversold Bounce or the Start of Another Rally Leg

by
Keene Little

The market was set up up for a bounce today and a bounce we got. There's nothing like a bear market rally to behold. It's too bad the volume on the up day was not as strong as it was for yesterday's down day. But let's not get sidetracked with details (wink) as today clearly looked bullish. While different indexes and sectors give us a different picture of whether support held or not, there were other factors that set the market up for today's rally and the GDP number released at 8:30 AM was as good an excuse as any to torch the bears and get some short covering going. The DOW rallied 100 points in the first 30 minutes, stalled for a bit and then tacked on another 100 points during the day. The DOW finished just shy of +200 points for the day, the biggest one-day rally since July 15th.

The preliminary release of the GDP number for the 3rd quarter was a good one, and the first positive one in a year and the strongest in two years. The economy expanded at a +3.5% annual rate from the 2nd quarter to the 3rd quarter, which was in line with expectations. Goldman Sachs had come out late yesterday with a downgrade in their estimate, lowering their expectation for growth from +3.0% to +2.7%. Many think GS has an inside track into all things government and therefore today's number probably took a few people by surprise. The sharp upward reaction was evidence of that.

Many feel this report is good evidence that the recession has already ended and it's just a matter of having it officially recognized. In fact it's universal--all 55 economists who are regularly polled about the economy are in full agreement about growth expectations for next year. Not one thinks we could even have a double-dip recession, never mind something worse. When they all agree on something it's been historically proved that you should take the other side of that opinion.

If we look inside the report and see why GDP grew, it raises some questions about what we can expect for the 4th quarter. The improvement in GDP was attributed to an increase in consumer spending, a slowdown in the reduction in inventories (i.e., it was "less bad"), an increase in residential investments and strong government spending (cash-for-clunkers, home-buying credit, stimulus spending, etc.). One thing to remember about government spending, even if it does increase GDP, is that it is destructive rather than constructive. Government spending doesn't produce anything. It's only redistributing money it collects from you and I. Therefore an increase in government spending is an increase in destructive behavior. And you remember what your parents taught you about destructive behavior.

So what has been happening since we've started the 4th quarter? We've seen the consumer sentiment drop and spending decline, a further reduction in inventories and government spending has declined (some in Congress are actually becoming concerned about the debt load). In other words, a one-quarter increase does not make a trend. The consumer sentiment dropping back down is scary enough. The lowest it got during the 2001 recession was 84.9. It's currently 47.7. It's not hard to imagine the negative impact of a souring consumer.

Of course all reversals start with baby steps and therein lies the hope. Maybe the 4th quarter will be lower growth than the 3rd but any growth would be good. The problem is the economy needs some pretty solid growth quarter to quarter in order to correct the bad decline over the past year, as can be seen in the following chart:

GDP and Deflator, Year-over-Year Percentage Change, Quarterly chart

The uptick for Q3 is a start but as you can see it also might just be an "oversold" bounce. Only in hindsight will we know for sure but so far the reports we've been getting tell us GDP will not be as strong in the 4th quarter. I don't want to be a pessimist about this but the facts remain that there are a lot of systemic problems that have not gone away yet, the credit contraction being the biggest one. Ask any small business owner whether he or she feels like the economy is growing and I doubt you'll hear an affirmative response.

So today's rally was either the start of another leg up to what will be another new high next month (there are some cyclical studies pointing to that possibility) or else it was just another hope-filled, short-covering inspired rally that will get reversed quickly. Volatility has certainly increased in the past few weeks and this is normally associated with topping action (bottoms tend to be v-shaped while tops tend to be rolling affairs with more of a battle between the bulls and the bears).

Part of the battle at tops shows up in a statistic called buying climaxes. This is a term used to describe a stock that achieves a new high for the day/week but then closes below the previous day/week's closing price. An outside down day/week, or bearish engulfing candle would be representative of this kind of price action. The market will often show a spike in buying climaxes at market highs. InvestorsIntelligence.com keeps track of these and their conclusion, based on the buying climaxes over the past few months, is that stocks are being distributed from strong hands (smart money) to weak hands (retail, which includes mutual fund managers).

The report from InvestorsIntelligence on Monday for last week showed a spike to 602 stocks achieving a buying climax by hitting new 52-week highs and then closing the week lower than the previous week. There have been only five previous occasions in their database where the number has exceeded 500 and it brings the total for October to over 1400. This is a very strong sign that the market is topping, if it hasn't already topped. The same behavior was seen at the October 2007 high.

So back to the original question--was today's rally just a strong oversold bounce (the market was short-term very oversold) or the start of another big rally leg? One could argue either scenario but I'm sticking with the more bearish one that calls a market high as already in. As always, we'll let price lead the way and not argue with it and we'll let the charts help us in that regard.

I'm going to start with a longer-term view of the granddaddy of the indexes, the Wilshire 5000. The monthly chart shows why price is struggling where it is. I've drawn in a horizontal line at 11000 which is the area where price has found support and resistance since 1998. The 20-month moving average, currently at 10728, has also been support and resistance and the 50% retracement of the 2007-2009 decline is at 11356 (the high on October 21st was 11360). Today's close just under 10924 is right in there with all this resistance overhead. Today's close is also very close to September's close near 10912 and it's hard to see the squished candles on the chart but this month's is a long-legged doji, which is oftentimes a reversal candle (requires a red candle for next month to confirm in which case it would be a longer-term reversal pattern).

Wilshire 5000 index, DWC, Monthly chart

The weekly chart of the Wilshire 5000 shows the downtrend line from October 2007-May 2008 which was also resistance to the rally. So there was a lot conspiring against the bulls from driving it any higher than they did. This week's low was a slight break of its uptrend line from March-July but today's rally had it recovering back above its uptrend line and that keeps rally hopes alive.

Wilshire 5000 index, DWC, Weekly chart

The S&P 500 also broke its uptrend line from March yesterday and squeezed in a recovery above the line, currently near 1061, with the rally into today's close just above 1066. More importantly, for bullish hopes, is the fact that it held the uptrend line from August, closing right on it yesterday, which was part of the reason I suggested at the end of the day yesterday in the Market Monitor that we'll probably get a bounce today, especially since the market closed right near its lows (a small capitulation into the close after heavy selling usually sets up a reversal the next day).

The bulls will want to see some follow through on the buying on Friday in order to confirm this wasn't just a one-day wonder (similar to the strong rally on October 22nd). One reason has to do with where SPX stopped today--at the top of a parallel down-channel from last week's high. Parallel channels do a great job identifying a trend so if the current down-channel is the new trend then we should see an immediate reversal back down on Friday. As with the small capitulation into yesterday's close, today's capitulation into the high may have set up an immediate reversal back down tomorrow. I've found it's usually more reliable to look for a reversal after a strong move rather than a continuation of the move.

S&P 500, SPX, 60-min chart

A break above 1070 would tell us something more bullish is in play. It will either head to new highs next week (dashed line on the daily chart) or it will simply get a higher bounce before heading back down. There's no way of telling which might happen but it would say shorts would want to step aside and watch for a bit. I trust the upside as far as I could throw a full-sized bull. I've got a wave count on the above chart that calls for another leg down to complete a 5-wave move down from last week's high. That would then set up a larger bounce next week to correct the decline.

But here's the risk for bulls and I think the risk should be seriously considered. I never like to talk about crashes because they're so rare. But the strength of today's rally, on lower volume, sets it up (not to mention the psychology of the market). If today's bounce is another 2nd wave correction, like the one on October 22nd, instead of the 4th wave as I have it labeled, it means the market is set up for a very strong 3rd of a 3rd wave down (a crash leg). You don't want to be long if that happens since we could see a drop of 50 S&P points easily in a day. It could equate to a -500 drop in the DOW. As I said, I never like predicting that kind of move and I'm not doing it now. I'm only pointing out the risk and if we see selling get very strong from here it will significantly increase the odds that it's happening (otherwise a 5th wave down should have less breadth than the previous 3rd wave down). Stay very attentive here.

The DOW looks relatively stronger than the rest. It has not sold off as much and therefore has done a better job holding above support. It looked dicey yesterday after it broke its uptrend line from July but it hasn't yet tagged its 50-dma and it recovered back above its shorter-term uptrend line. The more important uptrend line from march is down near 9600, almost 400 points away. Of all the charts reviewed for tonight this is the one that looks like new highs are coming (up to the 10200-10300 area). But if the DOW drops below 9600 the others will look even worse and the DOW will simply be confirming what we will already know by then--the top is in.

If the DOW looks potentially bullish the NDX already looks bearish as it has broken both its uptrend line from March as well as the one from September. Today it wasn't even able to bounce back up to either line, let alone recapture them. But today was an inside day (trading inside yesterday's trading range) and candlestick is called a harami, which is a potential reversal pattern. Confirmation is needed by an up day on Friday in which case we'd have a bullish reversal signal. This is another reason Friday's price action is going to be important for how next week goes.

The RUT is the other index that leaves a bearish taste in my mouth (kind of like succulent filet mignon). The strong break below its 50-dma, uptrend line from September and uptrend line from March, not to mention the break below the October low, are all signs that we've seen the top to its rally. I suppose it would be possible for the DOW to make a new annual high and not the RUT (which would be bearish non-confirmation) but that would be just speculation from here. However, like NDX, today's harami candlestick could be pointing to at least a higher bounce, perhaps to the 600 area, before heading lower again. Back above 600 would be more bullish and that could be when the blue chips are pressing towards new highs.

The banking index (BIX) looked like it was breaking down yesterday after it broke all of its support levels--the 50-dma, uptrend lines from March-September and the one from July. Today's recovery got it back above two of those three but stopped at its March-September uptrend line. Once again, a further rally on Friday would have the BIX doing a nice recovery off another head-fake break to the downside (used to build up some short-covering fuel for another slingshot ride higher). But a reversal back down would leave a bearish kiss goodbye. Have I mentioned Friday's price action is going to be important?

Banking index, BIX, Daily chart

The BIX is made up of many of the banks we hear about regularly in the news, such as BB&T, Fifth Third Bancorp, Keycorp, M&T Bank, SunTrust and Wells Fargo. Another banking index (BKX), is the KBW Bank Index, and is a capitalization-weighted index composed of 24 national money center banks, spread across the country. Representative banks include some of the same banks as in the BIX (such as BBT, Fifth Third, Keycorp, M&T, SunTrust and WFC) but also includes BAC, C, JPM, State Street and Wachovia. This index is actually looking a little weaker than the BIX and is definitely worth watching here.

The lows in August, September and October formed a support shelf at the same level as the high in May. The market obviously felt this level was important. Yesterday's selloff broke that support line and today's rally recovered back above it. A one-day break is a warning shot across the bow but the ship hasn't stopped yet and may be able to outrun the shooters (the bears). But any further selling in this index will be bearish, period.

KBW Bank index, BKX, Daily chart

An index that I've been surprised at how well it has held up is the DJ Equity REIT index (DJR). We've all heard how quickly the commercial real estate market has collapsed in the past year and home real estate has only marginally improved. This is an area that sports eternal optimism and I think it's about to bite them. Yesterday's decline took DJR below support near 160 but today's rally popped it right back above the line. It has already broken its uptrend line from July and given it a kiss goodbye at the lower high in October. The wave count is set up for a strong selloff to follow and unless it can get back above 170 I think it's about to drop hard.

DJ Equity REIT index, DJR, Daily chart

SRS is an inverse real estate ETF and is a way to play the downside with a purchase (for something like your retirement account). I received an email from a reader who has been building a position with SRS and in it he stated, "FWIW, I am working with a top asset protection attorney on my own affairs and this morning on our call I asked him if he was seeing anything related to commercial real estate. His answer shocked me. He said I am the only non-commercial real estate client he has worked with in quite awhile. They are scrambling to protect their personal assets before the [defecation] hits the [rotary oscillator]. He said from his perspective, it is going to be very bad." So that's some insider (legal) information from people in the industry that supports what I'm seeing on the chart.

There's not much to add to the home builders index that I haven't been saying for the past several weeks. The decline should continue and eventually break its uptrend line from November 2008 (think of the one-year rally as a big bear flag pattern). Note the rollover of MACD after it bounced up to the zero line when it tagged its 50-dma. That's a usually very reliable sell signal right there.

U.S. Home Construction Index, DJUSHB, Daily chart

The transports have been one of the leaders to the downside and today's exuberant rally was not well support by the trannies. It was more or less a half-hearted attempt at participating. As long as the trannies look weak I think we need to consider the economy weak and that forces a negative evaluation of any hope-filled rally. The break below its October 2nd low is significant--it confirms the October high should stand as the high for the year and potentially the high for a long time to come. I do see the potential for the TRAN to rally up to the 3800 area for a retest of its broken uptrend line from March and its 50% retracement level but we should see more selling come back in.

Transportation Index, TRAN, Daily chart

The dollar has bottomed. At least that's what it looks like to me. And that's potentially very significant for the markets (stocks and commodities). Was it coincidental that a relatively big rally in the dollar on Tuesday was matched by a strong decline in the stock and commodities markets? I don't think so. And the dollar pulled back today giving the green light for the stock and commodity bulls to jump back in. Watch out if the dollar reverses back up, and I think it will.

The chart of UUP, the dollar ETF, shows a break of its downtrend line from March (while the stock market is breaking its uptrend lines from March--again, not coincidental) and the one from August. Today it looks like it's pulling back to what was resistance and should now be support, near 22.40. It takes a break above 23 to confirm the bottom is in but so far the wave count, price projection and trend lines, not to mention the bullish divergences and extremely bearish sentiment towards the dollar, all support the idea that we've seen the low for the dollar. The next move should be a rally above the March high (so what does that tell us stocks might do?).

US dollar ETF, UUP, Daily chart

Gold got a big bounce with the stock market today. Notice that the metals are trading with the stock market? This is part of the all-the-same market and why there will likely be few places to hide when the selling kicks in harder--most assets will sell off as the dollar rallies. Gold is still holding above its uptrend line from August and that keeps alive the potential for another leg up to a new high (I'm showing upside potential to 1080-1090 but I'm aware of a Fib price projection around 1134. For that to happen we'd surely need to see the dollar drop to new lows. The September high of 1025.80 is acting as support for now but if that breaks we'll have a break of price support as well as the uptrend line from August and that would suggest we've seen the high for gold and like the stock market may be in for a long decline into next year.

Gold continuous contract, GC, Daily chart

Last week I showed the weekly chart of the gold miners and the setup for a reversal back down. This week we've seen a strong decline and a bounce off its uptrend line from October 2008. It's in a bullish up-channel so a call for a top could be early but the setup is good for a top. Confirmation requires a drop below 41 which will be a drop out the bottom of its up-channel and a break below its 62% retracement.

Gold Miners, GDX, Weekly chart

As with gold I see the possibility for one more high for oil and a price projection near 83 makes for a good target. It's still early to make a call for the high in oil but so far it's a good setup. It requires oil to head back down from here and a break below 70 to confirm we've seen the high.

Oil continuous contract, CL, Daily chart

Tomorrow morning will be busy with economic reports. The market will be looking for confirmation from the personal income and spending levels that the consumer will continue to support growth in GDP. You can see in the table below that the expectations are for both levels to drop, not very conducive to GDP growth. If the number comes in even less, look out below. The same with the Michigan Sentiment number--if it shows a drop below the September number it could spook today's happy bulls. The flip side of course is that these numbers could blow away to the upside in which case we could see today's bottle rocket ignite the second stage instead of flame out. The Chicago PMI needs to stay above 50 in order not to spook the market.

Economic reports, summary and Key Trading Levels

Summarizing tonight's charts, the bulls pulled their collective fannies out of the fire today. They got their fur burned off but a closer inspection reveals no significant damage. The bears in turn got their fannies roasted on an open fire today and are going to try to get the bulls to sit down on the fire tomorrow. As with the mini-capitulation selloff into the close on Wednesday, followed by today's strong rally, we could have a complete reversal again tomorrow following today's mini-capitulation into the close. The market works in a perverse manner and tends to catch the most people leaning the wrong way most of the time.

Depending on which index or sector you look at it's easy to argue support held or resistance held. Only with further price action will we know better which one is stronger. I'm leaning towards the short side because I liked the setup last week for a top to the market. I'm looking at the market with my bear-colored glasses (a shade of brown vs. the bull-colored glasses which are a shade of pink or rose) and therefore I'm looking at today's bounce as just a correction to a very short-term oversold market on Wednesday.

But the bearish view requires almost an immediate reversal back down tomorrow. That would mean either a negative reaction to tomorrow's economic numbers or a quick reversal to a positive reaction. A continuation of the rally would make it much more bullish and increase the probability (not certainty) for new highs into next month.

The techs and small caps (NDX and RUT) have broken their uptrend lines from March and August and have not recovered back above them. The blue chips (DOW and SPX) are both holding those support lines (the SPX is barely holding its March uptrend line), as is the big one, the Wilshire 5000. So the question tonight is whether you believe the techs and small caps will lead the way, which would be bearish, or the blue chips will drag them kicking and screaming higher. Usually the small caps and techs lead the way and that's the other thing that has me leaning bearish.

I'll mention one more time in case you missed it in my discussion under the SPX 60-min chart: there is the possibility that the wave pattern is predicting a crash leg next. I don't like to even mention these because they're rare. But if selling picks up speed tomorrow it could be pointing to a very strong down day, if not on Friday then on Monday. I'll update that potential in the Market Monitor tomorrow. Obviously that potential weakens significantly if the rally continues tomorrow.

Regardless of your bias (and I'm talking to myself here), don't argue with price. Look for your entry but only after you've identified the price level where the market proves you wrong and get yourself stopped out at that level. Your trading time frame determines where you enter and place your stops, depending on where you think support and resistance is. Look for both sides of the trade and constantly challenge yourself as to why you're wrong about the market.

Look for things that confirm you're wrong rather than why you're right. If you're right, great, the trade will work and you stay with it. If you're wrong you get out of the way quickly. As the trade starts working for you start thinking about where the trend changes and be ready to take your profits off the table. If you stay with a trade, use the house's money while yours is safely back in cash. In a volatile market it is better to take your profits often and run. That again depends on your trading time frame and how much you're willing to let the market move against you before you're forced out of the trade. Don't let a winner turn into a loser, don't eat yellow snow and call your mother once a week. That about covers the rules for a trader.

Good luck and I'll be back with you on Monday as Todd and I switch days next week.